Government must tackle the UK’s “debt hangover” as the period of low interest rates comes to an end

24th July 2014

The UK’s household debt hangover must be a priority for the next Parliament as the end of the holiday period for borrowing costs draws nearer a new report has warned.

The research from independent think tank, the Resolution Foundation, has cautioned that even a small rise in interest rates could have a major impact on highly indebted households over the medium-term.

It concluded that the number of highly geared households spending more than a third of their post-tax income on servicing their debt could more than double from its present 1m to around 2.3m by 2018. The market expects rates to climb to almost 3% over this period.

A rise in the cost of borrowing will spell the end of a holiday period for many who have been able to take advantage of rock-bottom interest rates of 0.5% per cent for the past five years.

The Resolution Foundation report says that the country needs shaking from its complacency about the implications of this return to a world of more normal interest rates, particularly for a minority of highly-exposed borrowers. It argues that careful action now, while interest rates remain low, can avert or mitigate the worst of the fall-out for households and the wider economy.

The scale of the UK’s household debt is considerable – £1.6 trillion (or 142% of household income) which is projected to rise to £2.2 trillion by 2018.

The problem is particularly acute for those with low to middle incomes. Among borrowers in the poorest ten per cent of the income distribution, three-in-four face becoming highly geared as interest rates rise. Yet this exposure has been masked as most discussions on household debt look at the population as a whole rather than those on low incomes.

While many of the highly-geared borrowers will still be able to refinance their loans and search for competitive deals, an estimated one-in-three of them – or 800,000 – may find their options restricted because of tighter lending conditions since the financial crisis. These potential ‘mortgage prisoners’ may have no option but to remain on their existing lender’s Standard Variable Rate (SVR) leaving them fully exposed to the passing on of increases in the Bank of England’s base rate.

With these challenges in mind, the Resolution Foundation is calling on the Bank of England to tread carefully on interest rates until there is reliable evidence of incomes rising.

Matthew Whittaker, chief economist at the Resolution Foundation, and co-author of the report, believes it would be a serious mistake to think that the legacy of problem debt built up in the pre-crisis years will simply evaporate with a return to economic growth.

He said: “The magnitude of the stock of debt is simply too large given expectations that income growth will be gradual at best.

“We need an orderly and carefully-managed approach to managing the debt overhang in order to minimise the numbers pushed over the edge as borrowing costs rise and to improve the safety-net in place for those who can’t avoid such an outcome. A recovery which sees living standards rise right across the income distribution would, of course, be the best approach to managing debt.”